Tuesday, January 17, 2012

What is happening?

Everyone with the capacity for rational thought understands that something is not right. Defining that feeling is more of a challenge as humans default to a linear pattern of thinking when facing change. We have been practicing radio silence as there is really not much new to report. The systemic issues plaguing markets as we know them remain.

We wish to provide an update that you may choose to consider. Perhaps another cup of coffee should be poured before digesting the following as your college macroeconomics professor did not equip you with the skills required for dynamic thought.

Gold has retreated from its all time high in early September. Remember, we are discussing the price in dollar terms in this chart. Over a six month period notice that $USD gold has advanced by 2.88% in the spot market.

Now lets have a look at what a European purchaser of gold has experienced over the same period. If you live in Europe, you likely own gold in euro terms. While a similar high was attained in early September, the overall performance has been 5 times that of the same dollar denominated investment.

In previous posts we have demonstrated that the central bank controlled crash landing has been characterized by taking turns as currency weakeners. Now let's look at what the dollar and euro have done during this period. We will use popular ETF products to demonstrate this move.

Notice in early September the dollar began to strengthen. In the next chart, you can see that the euro begins to weaken at exactly the same time.

Obviously currencies trade against one another and strength in one equates to weakness in another. But, in the context of gold, consider that the dollar has been on a tear--increasing nearly 15% to a basket of its paper currency peers. With this dollar strength in mind, you can see that gold has still continued its ascent in real terms when priced in dollars.

So What Happens Now?

The world seems to be obsessed with rationalizing current events in order to find a desired reality. Our mission is to help you cut through that temptation and see the perils that your balance sheet faces.

Europe is grabbing headlines and we urge you to disregard nearly all written opinions on the subject. There is really no story here as the bloated, over-leveraged system that has been created is not sustainable. A headline stating that a "rescue package" has been assembled is not news. The rescue package is akin to giving the junkie $500 and calling it a fix. Yeah it is a fix, he will be fine for a few days. Then reality will be back and the withdrawals will induce a more violent search for relief. Don't come begging here, you won't find any sympathy.

The European system is drastically over-leveraged. There are two ways to fix it:
  • Outright Default
  • Default via Devaluation
These are the only two options that exist. Any person who espouses austerity should be immediately disregarded. Austerity can cure a 3% current account deficit in static terms. When a nation has ongoing deficits of 10-15% of GDP along with 100% or more total debt to GDP the last thing it can handle is reduced economic activity. If government spending is 20% or more of GDP and you reduce spending to balance the budget, GDP will be dramatically impacted. This creates enhanced pain for the populace. Considering they have no jobs or savings, we are struggling to see how the society will avoid outright revolt?

Now let's have a look at the US. We are running an estimated deficit of 12% of GDP. So, this year we need to sell an incremental $1,500,000,000,000 of debt just to finance current spending. There is no problem present here though as our central bank will purchase this debt masking the true nature of the problem.

Debt continues to be issued at rates near 0%. This does not seem sensible as a company behaving in this manner would be in receivership.

Catalysts For Explosion

Private lending, of which there is currently very little, derives its rates from those set by government auctions. Usually the arrangement is 10-yr government rate + a risk premium.
Terms can also be set using LIBOR, the 2-yr, 5-yr or even 30-yr. Banks borrow short and lend long taking advantage of an upward sloping yield curve. This entire model assumes that the government financing system is functioning in a normal fashion. Also consider that we have been in a 28-yearr debt bull market. Most market participants do not think that rates can rise and who are we to prove them wrong?

If you can find even one person that will hear a rising rate thesis, they will quickly tell you that lenders have offset this risk by using swaps. Remember, the advent of the derivative contract has allowed everyone in the world to mitigate any and all possible risks. In this case, a swap can be purchased that will act as an insurance against rising rates. If the second half of a 10-year term loan at 5% is subject to market rates of 10%, the swap will pay the bank for the difference.

Here is where we see there being a possible problem that could end in disaster. The Bank of International Settlements reports that as of June 2011 there were over $700,000,000,000,000 in outstanding derivative contracts.

Notice that 78% of these contracts are based on interest rate scenarios. As long as rates stay flat or fall the originators of these agreements collect premiums and suffer no loses. We must assume that the bulk of these contracts insure holders against a rise in rates? If that is the case, only 4% of them need to be triggered in order to wipe out 100% of the capital in the entire world banking system.

Is this a reasonable situation considering that every Western government is running a severe and uncontrollable current deficit. In addition to current bleeding, these nations have debt to GDP of between 80-120% respectively. The world GDP is roughly $65,000,000,000,000 and more than $10,000,000,000,000 in debt will need to be rolled over this year alone.

Finally, central banks may continue to create money out of thin air to purchase debt in an effort to keep the system from collapsing. If this condition persists, at some point a rational person must assume that a rate greater than 0% would be demanded on borrowed capital.

When considering these conditions, it is very challenging to envision a scenario that is bearish for gold prices over the next several quarters.

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